How do Prepaid Cards Work?

Prepaid cards work like credit cards when you’re shopping, but there’s one major difference: instead of borrowing money (like you do with a credit card), you’re spending your own money. Before a prepaid card can be used, you load it with funds so that you can spend those funds over time.

How Prepaid Cards Work

Prepaid cards look and feel just like standard credit and debit cards. They are plastic cards with a magnetic stripe (and they may also have a smart chip for security). To buy something, just act as if you have a credit or debit card: swipe the card if you’re at a retailer or type in your card number if you’re shopping online.

Where does the money come from? To spend money with a prepaid card, you first need to “load” the card with money – just like you need to charge a battery before you can draw energy from it. You might add funds to the card when you purchase the card (some cards are designed for one-time use, and come with a value of $100, for example), or you might add funds later. With some prepaid cards, you can re-load over and over, using any of the following methods:

Once you’ve added funds to your card, you can spend that money and withdraw cash at ATMs. But prepaid cards work differently than credit cards: with a prepaid card you can’t spend money you don’t have. Once you’ve used all of the loaded funds, the card won’t work until you load more (although some cards offer overdraft protection and similar features).

Why Use a Prepaid Card?

Prepaid cards get more and more popular every day. Some of the reasons include:

No credit needed: anybody can “qualify” to use a prepaid card. Because you’re not borrowing money, the card issuer will not check your credit scores before issuing the card. This is especially appealing to people with less-than-perfect credit, including young people who have not yet built up their credit. Some people even make the choice to live life with no debt (or credit scores). However, some consumers with a history of writing bad checks have reported difficulty with certain card issuers.

Control spending: if credit cards are a little too tempting, a prepaid card can help you avoid going into debt. If the money is not loaded onto your card, you can’t spend it. Prepaid cards work well for teens and college students, although a standard debit card would also do the trick. Whether you use a prepaid card or a bank-issued debit card, make sure to find out if overdraft protection will allow you to overspend – and disable that feature if you don’t want it.

No bank account (fees) necessary: prepaid cards can work as an alternative to a checking account at a bank or credit union. If you can’t or won’t open a checking account (perhaps you’re not interested in using a bank, or perhaps banks are unwilling to open an account based on your credit or check writing history), a prepaid card allows you to enjoy the convenience of paying with plastic. In some cases, prepaid cards cost less to use than a bank account. Finally, prepaid cards can provide access to services like online bill pay and mobile check deposit – without the need for a full-fledged bank account (yes, you can live without a bank account).

Throwaway account: if you’re concerned about security or privacy, you might be hesitant to use your everyday debit or credit card in certain situations. A prepaid card works well as a throwaway account. Perhaps you’re traveling in an area that is notorious for credit card fraud, or you’re going to make purchases that you’d rather not use your everyday card for; a prepaid card can insulate your “normal” accounts relatively inexpensively.

Problems with Prepaid Cards

That all sounds great, so what’s the catch? Prepaid cards come up short in a few areas:

Consumer protection: prepaid cards do not provide as much protection to consumers as traditional credit and debit cards. For example, what happens if your card number is used fraudulently? What happens if your card issuer goes belly-up (your funds might not be insured by the FDIC). Consumer protection is improving, and many card issuers voluntarily provide benefits, but some cards offer much more than others.

Fees, fees, fees: although things are improving, prepaid cards are notorious for high fees and confusing fee schedules. In the past, the only time it made sense to use a prepaid account was if you could not open an account at a bank or credit union. Fees have come down, but you need to research charges and think about how you’ll use a card before opening an account. You might have to pay every time you use the card, check your balance, add money, or speak with customer service. Some cards charge monthly maintenance fees as well.

Building credit: prepaid cards do not help you build credit. They allow you to spend as if you have a credit card, but your activity is not reported to credit reporting agencies. If you need to build credit, consider whether or not a credit card (even if you’ll pay an annual fee) would work any better than a prepaid card.

Where are you saving? Prepaid cards make it easy to spend money, but it’s hard to save money (much less earn interest) unless you have an interest-bearing savings account. If paying a few extra bucks in bank fees means you’ll accumulate savings throughout the year – even if it’s just a mental trick to get yourself to save – it’s probably worth the cost.

Slippery slope to debt: prepaid cards are supposed to use your money – not a lender's. The idea is that you stop using it when you're out of money. But some cards encourage you to spend more than you have by allowing overdrafts (with steep fees). If you don't load the card yourself – if you get it as an advance on your tax return, for example – you're borrowing money and paying to do so.